Wednesday, November 30, 2011

The rate on the Fed Liquidity Swap has been changed today to the OIS rate + 50 down from (OIS +100).

The Fed: The rate on these swap arrangements has been reduced from the U.S. dollar OIS rate plus 100 basis points to the OIS rate plus 50 basis points. In addition, as a contingency measure, the Federal Open Market Committee has agreed to establish similar temporary swap arrangements with these five central banks to provide liquidity in any of their currencies if necessary. Further details on the revised arrangements will be available shortly.

The liquidity swap represents the Fed providing dollar funds to the ECB and other central banks while taking euros or other currency as collateral. The all-in rate should be around 60 bp. If the US chartered banks want to borrow from the Fed, they have to pay 75 bp – the so-called Discount Rate. Some have speculated that it makes no sense for the Fed to offer lower rates to foreigners than it would to the US banks and therefore the Fed intends to lower the Discount Rate.

MarketWatch: “It is now cheaper for foreign banks to borrow dollars from their local banks than it is for U.S. banks to borrow dollars from the Fed, so we could see a 25 basis point cut in the discount window in the coming days to level the playing field,” said Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets.

First of all that is unlikely because the Fed clearly stated at the last meeting that they want to raise not lower the discount rate:

FOMC Oct 3d Minutes: As another step toward restoring a pre-crisis discount rate structure, some directors supported increasing the primary credit rate by 25 basis points (to 1 percent) at this time. Such an action would result in a 75-basis-point spread between the primary credit rate and the upper end of the Federal Open Market Committee's target range for the federal funds rate. These directors favored a move toward normalization of the primary credit rate in light of current and anticipated economic conditions.

Second of all US banks are NOT borrowing from the Fed these days – they have no reason to. In fact they are lending via excess reserves.
The rate that is important is the “Fed Funds Effective Rate”, the rate at which banks lend dollars to each other overnight. And that’s sitting around 8-9 basis points.

Fed Funds Effective (FEDL01 Bloomberg)

The need for dollars directly from the Fed comes from the European banks (via the ECB) because US banks and US money markets are limiting their lending to them. Thus lowering the Discount Rate simply won’t make any difference.

Was the AMR (American Airlines) bankruptcy filing really necessary? Analysts are speculating that if AMR hadn’t pursued an orderly restructuring, they would likely be forced to go through this process in about a year (Bloomberg radio). This will allow AMR to come out of the restructuring swinging, with cash reserves and airplane leases in place.

Great. But one thing that remains uncertain is the AMR pension. Typically pension liabilities for a US firm constitute unsecured subordinated debt. That means that legally AMR could walk away from their pension obligations. And if they decide to do so, the US government would be on the hook. More precisely it is the Pension Benefit Guarantee Corporation (PBGC), a government agency.

From PBGC: American Airlines sponsors four traditional pension plans that cover almost 130,000 participants. As of today, the plans collectively had about $8.3 billion in assets to cover about $18.5 billion in benefits. If American Airlines were to end their plans, the agency would be responsible for paying about $17 billion in benefits; about $1 billion in benefits would be lost.

So PBGC would cut benefits some, but with $8.3 billion in the AMR pension assets, the taxpayer would be responsible for about $9 billion. And this is just a drop in the bucket relative to the amounts of obligations PBGC may be assuming. Below is a table by industry showing changes in assumed pensions:

2011 will see an increase of 33% in pension liabilities over the previous year. The agency is already running a $26 billion deficit. Talk about a bailout.

The hope of course is that AMR will reach a deal with the union in which it would keep the pension, while the union would agree to accept pay cuts. Otherwise there will be more financial pain for PBGC and the taxpayer.

Nigam Arora, a contributor to Forbes Online, wrote the following today:

Forbes: It appears that a big European bank got close to failure last night. European banks, especially French banks, rely heavily on funding in the wholesale money markets. It appears that a major bank was having difficulty funding its immediate liquidity needs.

"It appears" Mr. Arora? This certainly started a buzz in the market. Arora continues: "The cavalry was called in and has come to the successful rescue."

And where exactly are you hearing about this supposed bank failure? Maybe you can tell us how a 50 bp reduction in dollar borrowing rate would have averted a European bank failure?

Just because you are an engineer and a nuclear physicist, are we supposed to take your word for it? Absolutely no evidence of such an event has been provided in the article. So congratulations Mr. Arora. You get the Sober Look Hype Award.

We are doing well with the Hype Awards - two already this week, and that doesn't even count the La Stampa fiasco.

Bloggers, analysts, consultants out there love to preach about the dangers of sovereign CDS. It's the scary counterparty risk that will bring down the whole system when CDS triggers.

Bloomberg: With banks on both sides of the Atlantic using derivatives to hedge, potential losses aren’t being reduced, said Frederick Cannon, director of research at New York-based investment bank Keefe, Bruyette & Woods Inc.

“Risk isn’t going to evaporate through these trades,” Cannon said. “The big problem with all these gross exposures is counterparty risk. When the CDS is triggered due to default, will those counterparties be standing? If everybody is buying from each other, who’s ultimately going to pay for the losses?”

Really? So what happens when listed equity puts go in-the-money or futures have a violent move? Actually nothing. The same is true for standard CDS contracts. Nothing will happen when they trigger because these contracts are collateralized the same way that futures trading is collateralized with margin adjusted continuously.

RiskCenter: Exposures between two counterparties under an ISDA Master Agreement are typically subject to one of ISDA’s credit support annexes. Our margin survey indicates that over 70% of derivatives exposure is subject to these arrangements. But some of the entities that are users of other types of derivatives ‒ sovereigns, supranationals and corporates ‒ are not active in CDS. As a result, well over 90% of CDS are subject to collateral arrangements, and these arrangements are virtually all two-way (i.e., either party could post collateral to the other based on the mark-to-market value of trades between them).

CDS is not insurance because it gets marked to marked daily. That means as the credit quality of the underlying name deteriorates, the CDS is marked wider and incremental margin is posted to cover losses - daily. By the time the CDS triggers, the protection buyer has collected enough margin to cover losses. This is no different than shorting puts - the broker will call for margin daily.

It's amazing that many so-called "experts" are not aware of this process and continue to skew both the overall perception and public policy with their hype.

Big move in the market this morning, with S&P futures up over 2.5%. We had two major moves by central banks: China reduces reserve ratio and the Fed lowers the rate on its liquidity swap to the ECB (and other central banks).

It's a 50bp swap rate reduction and term extension to ease demand for dollars in Europe. The implication on dollar liquidity however is expected to be muted. The euro basis swap spread improved only slightly.

The markets are looking for reasons to rally and two reasons were given. The overall impact on the euro-zone crisis is still uncertain. Italian and Spanish bond yields have not budged.

Tuesday, November 29, 2011

The equity markets sold off after the close, with Morgan Stanley down 0.8% after hours and 3.5% correction intraday. At least a portion of this move was driven by the S&P "refreshing" their rating methodology for financial institutions:

Reuters: Standard and Poor's reduced its credit ratings on several big banks in the United States and Europe on Tuesday as the result of an overhaul of its ratings criteria.

A few surprising results: Most US and UK institutions got their ratings reduced by one notch, while ratings for firms like Deutsche Bank,
Societe Generale, Credit Agricole, BNP Paribas, and Credit Lyonnais were left unchanged. What changes in the methodology would explain this?

There are two factors impacting these new ratings in addition to the traditional "bank-specific factors" (see chart below):

1. Macro: the rating agency is focused on how strong the banking business is in that country. Is the economy reasonably strong, how creditworthy is the sovereign where the bank operates, how good is the regulatory framework, how strong is the private sector, etc.

2. External support: how much is the government of that nation willing to do what the Fed and the US Treasury did with the banking system in the US in 08/09?

So according to the S&P, because France and Germany are rated higher than the US based on the combination of the above criteria, there is a downward adjustment to the US firms. The US sovereign rating is lower, the economy is slow, the regulatory framework is getting worse, and the government is no longer willing to support the financial system in a crisis (in a way that say Germany, France, or for that matter Japan or China are willing to do).

This all makes sense, but should Credit Agricole, Credit Lyonnais, and Deutsche Bank really be A+, while JPMorgan Chase be A? With the eurozone crisis raging, here is a simple question - would you deposit your money at JPMorgan or Credit Agricole?

Several readers have pointed out that the AddThis "share" buttons were not working. People could not "share" a specific post. AddThis got replaced with Twitter, Facebook, and LinkedIn buttons. If anyone is looking to add other social media, please let us know.

Also below the "Recent posts" we now have some Twitter items - that's still work on progress.

The USD OIS (overnight index swap) spreads continue to stay elevated. The chart below shows the spread between the 2-year LIBOR swap (IR swap) and the 2-year OIS. This is the market expectation of 3-month LIBOR for the next two years vs. the market expectation for the interbank overnight rates for the next two years. The spread between the two is the market expectation for the next two years of premium on the 3-month loan rate vs. the overnight loan rate.

That means the market anticipates a prolonged tightness in dollar term funding even though the Fed is expected to keep the overnight rates near zero. The next chart shows the current LIBOR curve vs. the OIS curve. Without this premium for term funding, the two curves would be right on top of one another. But we have OIS curve following the Fed's trajectory - overnight rates near zero for the next two years, while LIBOR is "not listening" to the Fed because of the term funding premium.

LIBOR Curve vs. OIS Curve (Bloomberg)

In contrast, here are the same two curves in 2005 when "balance sheet usage" for term funding was not a concern. Those were the good old days.

LIBOR Curve vs. OIS Curve (Bloomberg) on 11/29/2005

Elevated OIS spread indicates banks' increasing fears of lending to each other for longer than overnight and is a good gauge of financial stress.

All is well with the world again. Italy sold €8 billion of new paper and the fact that there were buyers even at record yields pushed up the equity markets. French and Spanish bonds rallied in sympathy.

But at some point the world will remember that Italy has €33 billion of debt coming due in the final week of January and another €48 billion in February.

As US equity futures rally, the ECB continues to provide increased amounts of secured financing to European banks in a fashion similar to the Fed's TAF operations.

Bloomberg ECBATOT - Variable Rate Repo Auction Allotment.

These institutions then promptly convert some of those borrowed euros to dollars in order to fund their dollar assets, driving up demand for currency basis swaps. The spread on the 3-month EUR/USD basis swap has promptly crossed the psychologically important level of -150.

3-month EUR/USD basis swap (Bloomberg)

So all is well with the world as the equity markets continue to rally.

Monday, November 28, 2011

Some time back we discussed the tracking error associated with leveraged ETFs. Today we see another "side-effect" of these products. Today after a 3% rally in the US equity markets we saw a sharp upward move right before the close.

SPY (S&P500) - Bloomberg

One of the drivers of such a move is often a group of leveraged ETFs. Typically ETFs employ Total Return Swaps (TRS) provided by banks in order to obtain leverage. Some use futures. Usually on a day like today, the rally causes the NAV to grow faster than the assets the ETF holds (because of the leverage). So at the end of the day the NAV is "too big" for the assets the ETF holds, giving it less leverage than its intended target. This forces it to buy assets to get back to the expected leverage ratio. And the bigger the rally, the more it has to buy. Of course it works the same way on the down-side, with ETFs being forced to sell whenever there is a large market drop. See the example below.

This is equivalent to what options traders call being "short gamma". So when you see a big spike at the end of the day, just remember it's the "retail derivatives" products called leveraged ETFs at work amplifying market moves.

The CFTC is seeking industry comments on the ICE Clear Credit request for "Commingling" and "Portfolio Margining". As a bit of background ICE (the Intercontinental Exchange) is preparing a platform to clear credit default swaps (ICE would become a "clearinghouse"). It's a slow and tedious process because so many regulatory and "plumbing" (process/technology) issues need to be worked out for CDS.

In their infinite wisdom US politicians have split the regulatory oversight over CDS clearing. Index CDS (such as CDX) are to be regulated by the CFTC, while the SEC is to regulate "single-name" CDS (for example CDS protection on Ford). The rationale here is that the SEC regulates public companies - therefore "single names", while the CFTC deals with futures, many of which are indices. It is quite common for industry participants to have both types in the same portfolio, for example selling protection on one or more single names while buying protection on the index.

Of course neither the politicians nor the two regulators have fully thought this out. After all the futures industry lobby that has been pushing for CDS clearing does not fully understand how CDS is used in practice. Realizing the problem, ICE is trying to get permission to do the following:

1. Keep both single-name and index CDS in a single customer account (separate accounts for different customers of course) in order to allow clients offset gains on one with losses on the other. This is particularly helpful if the strategy is some sort of a spread trade or one type is used to hedge the other.

2. Allow portfolio based margining in this single account. That is if the long and the short CDS have significant risk offsets (short single name CDS vs. long CDX for example), the margin requirement would be reduced. That is the lower the risk, the lower the margin. Obviously there would be the "jump to default" margin charge for each position that can't be "hedged", but portfolio diversification would help reduce that charge.

This is a sensible way to structure CDS clearing and should be permitted. If the CFTC does not accept this request, it will put a significant damper on CDS liquidity, making it that much harder for institutions to hedge credit portfolios and reduce risk.
ICE Exec Summary Portfolio Margining

Reuters: "We are working intensively for the creation of a
Stability Union," the German Finance Ministry said in a statement.
"That is what we want to secure through treaty changes, in which we
propose that the budgets of member states must observe debt limits."

The discussion seems to focus around the full EU Treaty ratification with all the eurozone countries involved. The thought is that if member states sign on to strict austerity (effectively as prescribed by Germany), the ECB would be more amenable to supporting the eurozone bond market. It is hard to imagine this could be a quick process, given that it will involve member states' parliamentary maneuvering. The Italian yield curve flattened in response, with inversion between the ten and the two year notes now at around 30bp.

The short-covering rally is extending across major equity markets - part of it driven by rumors that the Fed is gearing up for QE2 (more on that later). However financial stress indicators continue to stay elevated. It's hard to fully trust some of the confusing language coming out of Europe. The chart below is the US 2-year swap spread which is maybe a basis point off the high.

The financial system, particularly in Europe is still quite stressed. This is not going to change until we see a concrete and plausible proposal with full details emerging from the key members of the eurozone.

This diagram came from one of the readers - we apologize for not having the original source/authors. But it is an interesting variation of the earlier post on possibilities around a "smaller eurozone".

BBC: The International Monetary Fund (IMF) has denied it is in talks with Italy about a new bailout loan.

This has to be one of the biggest journalistic blunders in recent years. Just because the story came from a NY reporter it has to be right? What happened to the editorial staff? La Stampa is the largest and most influential newspaper in Italy, founded in 1867. Selling a few more papers to ruin your credibility makes no sense. Such action deserves a Sober Look Hype Award, but that honor already went to Moody's this week.

Don't speak Italian? That's OK. This roughly says that the IMF is preparing a loan for Italy in the amount of 400-600 billion Euros at a rate between 4 and 5% (vs. 7-8% they pay now). Italy will have 12-18 months to comply with the IMF imposed reforms.

Two questions remain:
1. IMF does not have the funds discussed here. Who is providing them?
2. Where did LaStampa obtain this information? No sources seem to be quoted.

If true, this is an unprecedented rescue of a sovereign state by IMF and equity markets should indeed rally. One however should remain skeptical until some sort of an official statement or a corroborating source becomes available.

Needless to say the post wasn't flattering to the firm because it pointed out the irony that Moody's was teaching structured credit after what they had "accomplished" with the sub-prime CDO ratings, ABCP, etc. And charging over $4,000 for it in 2009.

The post contained a copy of Moody's old structured credit course brochure (available to the public on their website at the time). So they forced Sober Look (via Scribd) to remove the catalog for what they call a "copyright infringement".

A two year old publicly available course brochure? Really? Congratulations Moody's. You get the Sober Look Hype Award.

US equity futures rallied sharply on Sunday night on a story
that Germany and France are
exploring a smaller European union within or outside the eurozone with tighter
fiscal integration.

One approach is based on a smaller group of EU states that
would agree on stricter fiscal discipline, allowing others to join if they
agreed to abide by the same principals.
The other approach is an agreement just between Germany and France with others joining later.

Reuters (describing the two options): One is based on the Pruem Convention of 2005, also
known as Schengen III, a treaty signed among 7 countries outside the EU treaty
but which was open to any member state to join and was later acceded to by 5
more EU states plus Norway.

Another option would be to have a purely Franco-German
mini-agreement along the lines of the Elysee treaty of 1963 that other euro
zone countries could also sign up to, officials say.

The goal here seems simple – to ring-fence the
stronger nations within a tight union in order to contain the crisis. Alternatively this could be a maneuver to threaten the weaker nations to comply with quick fiscal integration that may involve EU Treaty ratification.

Source: CNBC

As usual there are no details available and the rally is based entirely on hopes (plus strong Black Friday sales and a strange story out of Italy - more on that shortly). It is not at all clear how this process will deal with Italy and Spain, which remains a key question.

Economists have long been downplaying the impact of the crisis in Europe on China's growth, but realities on the ground are hard to ignore. Fearing inflation, Chinese authorities have been slow to respond with a policy easing, but they are starting to pay attention.

Here is a quick video interview with Huang Yiping from Barclays Capital about the economic situation in China. Below are some highlights:

1. China Investment Corporation (CIC), China's sovereign wealth fund is involved in Europe. It has been buying some sovereign bonds, but is more interested in "real" asset purchases. For example as pressure builds on Italy to privatize some of the state assets, CIC may be a buyer.

2. Monetary policy easing in China has begun but is still in the form of "fine-tuning". Nevertheless the government is intent on pushing down property prices, thus will not support real estate based lending - yet.

3. China is pushing banks to do more lending to small and medium size businesses (SMEs) who are having a tough time obtaining credit and are struggling from the global economic downturn.

4. Barclays expects an official easing announcement in Q1 of next year in the form of a cut in reserve requirement ratio.

The slowdown of China's economy - much of it driven by the crisis in Europe - is starting to become visible.

The Sydney Morning Herald: As orders have dropped, factories have started to lay off workers, cut overtime and in some cases withhold pay. In Dongguan, scene of the most violent of last week's strikes, some 450 small and medium-sized factories have closed in the past 10 months as the overseas market has shrunk.

Propelled by years of strong demand and easy credit, China's manufacturers have become overextended and are having trouble facing a slowdown. In fact most of these companies have never seen a real slowdown and are totally unprepared to deal with the cyclical nature of the industry. More from the Sydney Morning Herald:

Thousands of workers clashed with police on Thursday at a footwear factory in the city of Dongguan after 18 workers were reportedly laid off and overtime was cut. A thousand workers went on strike on Tuesday at the Shenzhen factory of a Taiwanese electronics company. A day earlier, hundreds reportedly struck at a Shenzhen company that makes underwear and lingerie.
On October 28, hundreds of employees of a Dongguan furniture company protested in the streets after the factory boss disappeared without paying them three months' salary.

This unrest may continue to grow, spreading to a number of provinces. China's officials may be able to cook the growth numbers a bit, it's hard to ignore the nation's workers' discontent. China, as usual, resorts to their propaganda machine. "Are Chinese people truly miserable?" asks People's Daily:

"Misery" is a regular word today. From emotions reflected in the media and online, the Chinese sense of misery is increasing while happiness seems to be dwindling.

And the answer to the misery question from the propaganda machine (People's Daily) is:

Chinese people should believe that a better life awaits them and that the next generation will embrace a brighter future. People should also be confident in a more democratic and fairer society with less corruption.

Saturday, November 26, 2011

The last several weeks have been filled with a great deal of confusion around the eurozone common debt issuance or what some refer to as "Eurobonds". Just for clarification a "eurobond" simply means any bond issued in a currency not native to the country of the issuer. For example a US company bond issued and traded in Japan would be called a "eurobond" - but our financial media doesn't want to take the time to clarify this. So for the sake of clarity let's call this concept the Eurozone Bond - a shared debt issuance by members of the European monetary union or even the EU as a whole. The general concept is that all current member states' debt would be exchanged for a single set of Eurozone Bonds.

Angela Merkel continues to oppose this concept, sending shocks through the financial markets. Clearly from Germany's perspective this is a scary undertaking because the nation would be backstopping their indebted neighbors. In fact Germany's Constitutional Court ruled recently that any permanent structure that "would result in an assumption of liability for other member states' voluntary decisions" is unconstitutional in Germany.

But on the current path, in the absence of the ECB becoming a buyer of huge amounts of Italian, Spanish, Belgian, and possibly French debt, the eurozone will go into a tailspin, dragging Germany and possibly the global financial system and the economy with it. Given some of the market action during the past week, this is not an exaggeration.

Legally the Eurozone Bond could not be implemented without significantly ratifying the EU Treaties because such issuance would be based on "joint and multiple" guarantees of the member states. The legal framework of the EU currently does not permit that. And even if EU decided to attempt such an undertaking, the political realities would make it dead on arrival - not only in Germany but in nations such as Slovakia (as we recently learned during the Greece aid debate).

There is however an idea, originated by the EU Commission and circulating in Europe, which may offer some hope. It's called the "Stability Bond", a less ambitious approach to a common debt program. Two possibilities could be considered for the structure of the Stability Bond:

1. The issuance would be backed by joint and multiple guarantees that would only partially replace current bonds that member states have outstanding. It's definitely a less ambitious project and could be implemented more swiftly, but it still requires EU Treaty changes. There is also the issue of moral hazard with such an approach because member states may not have the full brunt of "incentives" to implement domestic fiscal adjustments necessary.

2. Another approach would involve multiple guarantees without the joint guarantee, yet have some sort of credit support (such as collateral). It's not at all clear how such structure would function.

In order to bridge from where we are now to a Stability Bond program, an intermediate step has been proposed (although informally) by the German Council of Economic Experts (GCEE). It's called the "Debt Redemption Fund" (DRF) and is meant to potentially be a precursor to the Stability Bond. The idea would be to pool government debt exceeding 60% of individual countries' GDP. It would involve a joint guarantee on bonds issued by DRF while committing participants to redeem the transferred debt within a certain period of time - for example 20-25 years. This effectively forces nations to get their debt below 60% of the GDP in a fixed amount of time. 20-25 years may seem like a great deal of time, but it would be an amazing success if the US for example could stick to a 60% target within this period. Here are some of the characteristics of the DRF:

1. The excess debt (above the 60%) would be transferred to the Debt Redemption Fund gradually. For example as member states' existing debt matures, DRF would issue it's own debt to finance the newly issued member state bond.

2. All countries with debt above 60% would be required to participate. This way the Debt Redemption Fund wouldn't be viewed as a "rescue facility".

3. The program may extend beyond the monetary union members, covering all EU members.

4. In order to participate in DRF, member states would need to adhere to a strict pre-agreed schedule of debt reduction.

5. Member states that do not adhere to their austerity program would be forced to issue bonds outside of the Debt Redemption Fund that would be subordinated to those issued by the DRF. The market would quickly punish these states by forcing them to pay significantly higher rates. Other penalties could be imposed as well. This would make it politically easier for states to stick to the plan and reduce the risk of moral hazard.

6. Because such a program would be viewed as a temporary solution, it may make it easier to fit in within the EU Treaty - maybe only with minor modifications.

7. The Debt Redemption Fund concept may be more palatable to Germany because it will set in motion a mechanism that forces austerity and greatly limits the possibility that member states will "voluntarily" issue extra debt, increasing the burden on Germany.

Once most of the member states reach the target of 60% debt to GDP ratio, the program can be rolled into a more permanent Stability Bond program.

Reuters: "The proposal balances risk-sharing -- which is limited in
time -- with very stringent programmes for fiscal
consolidation," said the European economic and monetary affairs
commissioner at a conference in Berlin

Clearly this is a complex undertaking fraught with numerous political obstacles, but at this stage it maybe the only path that offers a glimmer of hope.

Back in 2009 we discussed the rising leverage of Japan's public sector that seemed unsustainable. Today we find the situation of Japan's debt continuing to deteriorate in the face of increasing concerns about sovereign debt globally. It is a sharp lesson for the US as the dynamics of the two nations' paths are not significantly different.

The gross debt to GDP ratio has risen to 220% in 2010 (IMF), compared to say Italy at 119% in 2010. The argument one hears is that Japan is "different". It supposedly has high savings rate and JGBs are mostly held internally. But that assumption is about to be challenged.

First of all the high savings rate in Japan is a myth. Even though the overall private savings rate is high, the bulk of that comes from the corporate sector instead of households. As corporations de-lever, they are building cash reserves, but households are actually struggling.

From the G20 report:

Stagnating household disposable income has been
accompanied by a rising consumption share of disposable income and
declining saving among younger households, which has reinforced
dissaving done by elderly households.

Japan's extremely restrictive immigration policy has sharply impacted the nation's demographics, accelerating the aging of the population. That's another lesson for the US - restricting immigration with an aging baby boomer population is a recipe for disaster. The chart below shows projected numbers of the elderly as percentage of the overall population (source: the IMF G20 Report - below).

Increasingly households will be sellers of JGBs (Japanese government bonds) instead of buyers, and the government will have to look elsewhere to finance its bulging budget deficit. Simultaneously (just as in the US but more rapidly) this aging population is putting Japan's Social Security into the red as expenditures exceed receipts.

This applies further pressure on the government, escalating debt levels.

Extremely low rates have kept interest expenses under control (similar to the US), but that's not sustainable in the longer term.

Should JGB yields rise from current levels, Japanese debt could quickly become unsustainable. Recent events in other advanced economies have underscored how quickly market sentiment toward sovereigns with
unsustainable fiscal imbalances can shift.
In Japan, two scenarios are possible. In
one, private demand would pick up, which
would lead the BOJ to increase policy
rates, in which case the interest rate growth
differential may not change much.

As we've seen in Europe, market sentiment can change rapidly - even domestically.

Market
concerns about fiscal sustainability could
result in a sudden spike in the risk
premium on JGBs, without a
contemporaneous increase in private
demand.

It is entirely possible that in the very near future JGB rates will begin to rise due to increased risk premiums and we may see a steepening of the yield curve. This would exacerbate an already dangerous fiscal situation that is mired by a deflationary spiral that continues to persist.

Reuters: November data for the Tokyo area showed deeper declines that exceeded analysts' forecasts and backed the view that the Bank of Japan will maintain ultra-easy monetary policy for the foreseeable future.

A narrower measure of prices that excludes both food and energy fell from a year ago in a sign that the world's third-largest economy continued to struggle with lackluster job market, weak consumer demand and excess capacity.

The report below (IMF) goes through some ideas on what steps Japan could perhaps be taking to change their course. The US should be watching this situation closely as it closely resembles what Americans will be facing in the near future.

Friday, November 25, 2011

As a follow-up to a recent very timely post by PonzyFinance on basis swaps spread, we discuss how European banks are employing this tool. A basis swap is a quick way of converting a "floating rate" asset or liability from one currency into another.

Let's say I run a dollar denominated fund that wants to purchase a sterling loan. The sterling loan pays sterling LIBOR plus a spread. I can enter into a dollar/sterling basis swap where I receive sterling (that I use to purchase the loan), pay out dollars, and agree to return the same amount of sterling in return for dollars in the future. The exchange rate for the "spot" transaction and the reverse forward transaction are the same and would be locked on the day of closing. Until maturity I would be paying sterling LIBOR on my swap and receiving dollar LIBOR - plus/minus the basis spread. So I start with something that had a sterling notional and pays sterling LIBOR plus spread (the loan that I purchased) and convert it to something that has "synthetically" a dollar notional and pays dollar LIBOR - which is more appropriate for my dollar fund and has no F/X risk.

The chart below shows how one would could borrow euros and convert the loan into dollars via a basis swap. Note that the basis spread is driven by the supply and demand in the market.

This is the basis spread that market participants use to ascertain how "healthy" the financial system is. European banks have access to euro funding, but are quite limited in their ability to borrow dollars. This creates significant demand for the swap structure above. That demand translates into higher basis spread (often called the "Euro basis"):

3-month EUR/USD Basis Spread (Bloomberg)

As PonzyFinance pointed out, the 150bp level is approaching. So how is it that European banks get access to so much euro liquidity? Unfortunately the answer is disturbing - many are tapping the ECB. In particular the French banks are starting to borrow significant amounts of euros from the ECB, some of which they convert into dollars to fund the dollar component of their balance sheet (driving up the basis spread). The chart below from Barclays Capital shows the recent increases in the funding provided by the ECB to banks from Italy, Spain, and France.

Source: Barclays Capital (click to enlarge)

As US money market funds turn away from Europe, dollar funding becomes dependent on the combination of the ECB and the basis swap market.

Here is an old GS write-up that goes through some detail on basis swaps.

A distressed credit tends to exhibit the so-called "inverted yield curve". The reason is that in a bankruptcy the bond maturity generally does not matter - all pari passu (same seniority) paper tends to have the same recovery (thus the same discount). If you apply the same discount to shorter maturity paper, it will generally have higher yield (depending on the coupon) than the longer term bond from that issuer. Distressed bonds are said to "trade on price" rather than yield. For example a 10-year bond with a 5% coupon trading at 80 cents on the dollar would yield 8% (you can check this using the YIELD function in Excel). A 2-year bond with the same coupon also trading at 80 would yield 18%. Thus we have an inverted yield curve. This also holds true for inverted CDS curves.

So why did we start this beautiful Black Friday morning with a discussion of inverted yield curves? Because Italian government bonds are now trading in that fashion. Of course one can get an inverted curve, as was the case in the US in 07, due to expectations of falling short-term rates. That's why a traditional inverted yield curve tends to forecast a recession. But for the first time we get an inverted yield curve in a major sovereign nation (not counting Greece) due to credit risk - with significant probability of default priced in. This morning's auction of short-term Italian bonds was a disaster.

Bloomberg: The Italian Treasury paid 6.504 percent to auction 8 billion euros ($10.6 billion) of the six-month debt, almost twice the 3.535 percent a month ago and the highest since August 1997. Italy’s two-year bonds yielded a euro-era record 7.82 percent, almost 50 basis points more than 10-year notes.

We now have over 100 basis "inversion" between the 1-year and the 10-year Italian bonds.

Italian government yield curve - now and a month ago (Bloomberg)

This is a dangerous development because as discussed before it will put further pressure on European financial institutions (including French and German banks) who hold a great deal of Italian debt. Deutsche Bank is the one to watch in particular, given its size and leverage. It will also completely "crowd out" Italian corporations from rolling or obtaining new loans.

Thursday, November 24, 2011

Contagion comes in many forms. As developed economies faced slower growth, the natural movement of capital was toward emerging economies, where growth is expected to remain robust. But the crisis in Europe is spreading, leaving very few markets unscathed. China is facing a slowdown (more on that later). Capital is starting to flow out of resource rich nations of Latin America. The current view now is that these nations will be facing a slowdown. Brazil is now fully expected to lower rates.

"Today's fall (in the real) may also be driven by an increase in bets on rate cuts in Brazil," Shearing added.

Lower benchmark interest rates can sap some demand for emerging market assets. Brazilian policy-makers expect the local economy to be hit by the deepening crisis in Europe and slower growth in China, Brazil's top trading partner.

Indeed the first sign of capital outflows is the move in foreign exchange levels. The real is approaching new recent lows. The last time these levels were reached was back in the "dark days" of Sep-2011, when the "double dip" recession in the US was thought to be a certainty.

BRL (Bloomberg)

Mexico is feeling the outflows as well. The peso is now at levels not seen since 2009.

MXN (Bloomberg)

For those who remember 1997-98, will recollect just how rapid and violent contagion can become. Many emerging market nations' economies are healthier than ever to withstand a global recession (should one take place), but nevertheless these currency indicators need to be monitored for signs of increased risks.

On this beautiful Thanksgiving day, here is another text conversation from our friends Roy and Steve discussing MF Global. As crude as these conversations may be, they represent actual conversations taking place among finance professionals. The names have been changed but the content is real. Enjoy.

Roy: Interesting article. But one thing struck me. It said "the trade structure allowed the firm to book all the potential yields on the bond purchases at the same time the trades were made." This is odd.

Steve: No way. That's not US GAAP. Maybe they were allowed to accrue rather than mark to market - that's possible.

Roy: I think since it was done as "repo to maturity" (and classified as sale, so off the books), that the difference in bond yield vs. repo was booked up-front. Could that be it?

Steve: No way. I've seen people accrue the difference (banking book) - so you take the repo spread on a daily basis and add a day's worth of spread to the P&L each day.
Steve: So on a 3yr paper it would take you 3 years to take the full spread into P&L. Accrued on a linear basis.

Roy: Yes, that's exactly what I think is the case too. So I'm not sure what that article is referring to.

Steve: Probably the usual uninformed financial media. But ultimately they did mark the paper, right? That's what caused the big loss in their quarterly statement.
Steve: Also I think the lost customer money was used to post collateral on the repo. And the money is gone because it was used to cover losses.
Steve: And I don't think that's illegal. Customer deposit is effectively junior sub debt.

Roy: Yes, I agree about the marks, and the loss of the customer funds. And true, it was perfectly legal to use those funds for that purpose. That's the rule that Corzine fought to maintain!
Roy: The shortfall is holding firm at $1.2B. What a disaster.

Steve: Not sure customers knew the risk.

Roy: It was a well-kept secret. Now all those other FCMs [Futures Commission Merchants] are going to face huge restrictions of the use of these funds. It was a good part of their income. So Corzine just completely f****d their business model.

Steve: Yes. Who are some of the other big futures brokers?

Roy: The biggest independent one now, I think, is Newedge (formerly FIMAT)

Steve: Is it public?

Roy: FIMAT, of course, was a unit of SocGen. FIMAT was combined with the FCM unit of Calyon

Steve: Got it. So no other big standalone futures brokers out there?

Roy: You've got the IDBs [Inter-Dealer Brokers] (Icap, BGC Partners, Tradition, GFI, and TullettPrebon), which have FCM units. But they are not like Newedge or MF Global.

Steve: Right. It's a small part of their business. By the way, Goldman looked at buying MF Global, right?

Wednesday, November 23, 2011

As the US market closed for Thanksgiving holiday, a dreadful feeling came over market participants in the US. With rumors circulating that Germany may in fact be OK with a eurozone-wide bond program (more on that later), the US market still closed at the lows - nobody believes the stories coming out of Europe these days. S&P futures broke below 1160, a 7% drop for the month.

All 5 of the US "financial confidence" indicators are showing increasing stresses in the system. Here they are:

We are entering a dangerous period reminiscent of 2008 when a major debt market crisis turned into a crisis of confidence in the financial sector. Except this time it's the sovereign debt instead of the sub-prime mortgage debt.

All eyes tomorrow will be on Germany and the ECB for any signs of support. Happy Thanksgiving.

Germany is in for a rude awakening as investors come to the conclusion that the nation will have no choice but to support troubled European nations. It can do it in two ways - either through massive euro devaluation (via QE) or by increasing it's own debt burden (as it did with East Germany integration). This does not help German government debt. The eurozone crisis is starting to take it's toll as investors are abandoning all eurozone bonds, Germany included. The German 10-year yields have now gone above those of the UK and significantly over the US Treasury note.

Bloomberg

This is a dangerous development because it creates a confidence problem that quickly spreads to global financial institutions who have been trying to reduce their exposure to "fringe" European states and roll into the "safe" German paper.

How does that impact the US? Below is a regression plot of EUR/USD against the S&P500 since October-2011. The correlation is now above 0.85 - the Euro might as well be as US stock. And this correlation increase is not unique to the US equity markets. No market is safe.

Spreads on Belgian bonds hit a new high this morning and
Italian bonds continue to sell off with yields approaching their all-time high. Usually
on a day like this we would see what we call ”flight to quality”. But the definition of “quality” is rapidly
changing. This morning’s auction of
German government bonds was extremely poor:

From CNBC: “It couldn’t have been much worse. We’ve seen failed auctions before,
but the scale of failure of this auction is of a different order,” Marc
Ostwald, chief economist at Monument Securities, told CNBC.com.

After all the concern here is that Germany may have to step up to
support the rest of Europe, which is not positive. The result is ugly. The "risk assets" are all down:

US S&P500 Futures: down 1%

HY CDX7 (corporate credit): price down 0.3%

Oil: down 2%

Copper: down 2%

AUD: down 1.5%

So you would expect capital to flow into “safer” assets (the traditional "safe havens"). But that’s not happening.

5-Year Bund: price
down 0.6%

10-Year Treasuries:
price down 0.3%

Gold: down 1%

Yen: down 0.5%

It certainly looks like global deleveraging, but where is all the capital flowing? US short-term bills continue to trade at zero
or even negative discount rate. Some
capital is going into that. But the traditional
safe haven securities are losing their luster quickly.

Tuesday, November 22, 2011

In the past few months, even as all other indicators such as sovereign bond spreads (and even Spanish 3 month T Bill yields) have blown out wider, the EURUSD spot rate has remained very resilient, hovering in a very tight range around $1.35 to US $. There have been many reasons that have been postulated for this including French bank repatriating EUR (buying EUR while USD denominated assets) to plug capital holes and ECB remaining steadfast in not giving in to calls for a massive QE program in Europe.

Meanwhile, another indicator of the bank funding stress can be seen from the 3 month Euro basis currency swap below. At 134bps, it has reached levels not seen since the Lehman bankruptcy. The Euro basis swap shows the cost of converting floating rate EUR payments into USD. It is often viewed as a better and true indicator of stress. Something to watch out for if hits -150bps or lower.